China’s financial institutions are still weak: They lack
well-defined private property rights and the rule of law; they
depend on government manipulation and are divorced from reality.
Those weaknesses are evident as we watch the roller-coaster ride
that investors are taking on the Shanghai and Shenzhen
exchanges.

After more than doubling from a year ago, markets reached a peak
on June 12, then lost more than 30 percent of their value in a
matter of weeks. That rapid tumble has led to significant
government intervention to “stabilize
markets”—that is, to place a floor under stock
prices.

The People’s Bank of China quickly lowered benchmark
interest rates, relaxed the reserve requirement for banks and
injected liquidity into the market. Funds were extended to
state-owned brokerage firms through the China Securities Finance
Corp. in order to mitigate margin selling, and government wealth
funds were instructed to enter the market to shore up asset
prices.

More recent measures include a six-month ban on stock sales by
major shareholders controlling 5 percent or more of a stock, the
halting of trading on nearly 50 percent of tradable shares on the
two major exchanges, the end of IPOs by private-sector firms and
the relaxation of collateral rules for margin lending.

Establishing government-funded “market stabilization
funds” and other devices to tame falling markets may be
politically popular in the short run but can severely damage
China’s future development as a global financial center. What
China needs are free private markets based on limited government,
responsibility and trust—not more central planning and
control.

If investors cannot trust
the government to abide by the rule of law and protect private
property rights, the entire credibility of financial markets will
suffer and the reform process will slow.

Open markets require the free flow of information and the rule
of law. China lacks both. The latest measures to rig stock prices
can only undermine President Xi’s “China Dream”
of restructuring the economy away from state-driven investment and
toward a more balanced system.

The effect of strictly limiting the right to sell stocks while
pumping up demand has temporarily put the brakes on the downturn
but has undermined confidence in Beijing’s pledge to
liberalize capital markets. The transferability of shares is an
important component of stock ownership. If that right is weakened
by government intervention, the value of one’s property
decreases and the incentive of both domestic and foreign investors
to buy shares will weaken.

The attenuation of property rights as a result of stabilization
efforts is perhaps the most damaging consequence of the recent
interventions. If investors cannot trust the government to abide by
the rule of law and protect private property rights, the entire
credibility of financial markets will suffer and the reform process
will slow. Political forces will enter the vacuum and planning will
suffocate competitive markets.

Retail investors have played an important role in driving up
stock prices, and they have done so by buying on margin. The
announcement of the opening of the Shanghai-Hong Kong mutual
trading platform late last year—and the expectation that
Beijing was eager to use policy tools to stimulate asset prices in
the hope that higher prices would increase consumption and
growth—provided a bullish atmosphere.

The People’s Bank of China, like the Federal Reserve, has
engaged in financial repression, leading to negative real interest
rates. The lack of investment alternatives in China tempts small
investors to take on excessive risk. As such, stock markets have
become super-casinos. Capital controls mean that only the rich and
politically connected can get their money out of China while
lower-income families suffer.

China has taken steps to liberalize capital markets, but the
markets are heavily constrained, and all major banks and brokerage
firms are state-owned. The legacy of central planning resides in
the socialist market system that characterizes the allocation of
capital, primarily to state-owned enterprises.

If China wants to become a world-class financial center, it
needs a rule-based monetary policy designed to safeguard the value
of money and a financial system that is grounded in law and
liberty—rather than “stabilized” by the heavy
hand of the state. Until then, foreign investors will be wary of
riding the dragon.